The Securities and Exchange Commission late Friday said it was expanding its probe into potential market manipulation and was turning its attention to the largely unregulated, obscure area of credit-default swaps.
The SEC said it will require hedge-fund managers to submit, under oath, their trading activity in financial-company shares and related instruments such as credit-default swaps as part of its continuing examination of rumors and stock bets.
These swaps are insurance-like contracts that allow dealers, hedge funds and others to transfer the risk of corporate defaults to others. Sellers charge buyers fees to insure bonds and loans from default, and buyers can benefit if the cost of protection subsequently rises. Over the past two weeks, large price declines in brokerage stocks were often accompanied, or preceded, by big moves in credit-default swaps tied to those firms.
The swaps trade directly between institutions, not on exchanges, and many investors believe their prices can be easily manipulated. They have become an increasingly popular way for firms to gamble on the fortunes of financial companies without actually trading securities issued by the firms.
The cost of default insurance for Bear Stearns and Lehman Brothers Holdings Inc. spiked in the days before both Wall Street firms collapsed. In both cases, elevated swap prices fueled worries about the investment banks' solvency, triggering mass defections among clients and ultimately the companies' demise. Bear is now part of J.P. Morgan Chase & Co.
In the past week, a jump in the value of credit-default swaps tied to Morgan Stanley and Goldman Sachs Group Inc. set off similar concerns at both firms. On Thursday morning, swap sellers were charging buyers more than $900,000 annually to insure $10 million of Morgan Stanley's obligations from default over five years, a price typically associated with highly risky or distressed companies. The prices had doubled from Monday and tripled from the week before. On Friday, after the SEC announced its short-selling curbs, the cost fell to $560,000.
Because credit-default swaps trade off exchanges, they are outside the scope of regulators. Growth of the swaps has exploded in recent years, and prices have often swung sharply ahead of major corporate news events, triggering suspicion that nonpublic information was leaking into the dealer market.
Still, the SEC hasn't brought any big cases involving credit-default swaps. There is a big debate over whether credit-default swaps are securities and thereby subject to SEC fraud laws or other instruments that would fall outside of the agency's jurisdiction.
The International Swaps and Derivatives Association has argued the latter, while the SEC has taken the position that swaps that reference securities such as bonds and are subject to its oversight. The distinction hasn't yet been tested.
Friday, the SEC also said it authorized its enforcement staff to issue subpoenas to gather information. The SEC staff already has sent subpoenas to more than 50 hedge funds as part of rumor investigations involving Bear Stearns and Lehman Brothers.
If they want to make it easy on themselves, they should just forget about the Investment Banks and just subpoena the buyers of credit default swaps on GE capital!
Who are "they" looking for? And why are Credit Default Swaps so profitable? Because the seller collects the premium, and puts no money up. Just their "rating." They just promise to pay. Do you think the seller of the CDS cares if he can overcharge? And then seller of the CDS, just turns around and buys swaps from someone else, hopefully at a lesser cost than what he just sold.
So a buyer of CDS' on Morgan Stanley, could of off-loaded their swaps and made 200-300% on them. In a week! That's good action.
That's how AIG got in trouble. AIG, if downgraded, would of had to put more collateral to pay claims on it's credit default swaps, and they weren't in the swapping business. They sold them, but didn't resell these swaps to someone else. It's like the neighborhood bookie. He offloads most of his action to Vegas, and keeps the "vig" himself. But AIG became Vegas. AIG forgot to circle the game!
So when some of these sellers of swaps got in trouble, they just shorted common, against their position. If you have to pay up on the swaps, at least make up the difference on the crushed common. And when this panic starts, it feeds on themselves.
A lower stock prices increases the panic, and the increased panic increases the cost of the CDS protection. But this time it wasn't the sellers of the CDS that were shorting the common. It was the buyers who brought the protection!
They won both ways. By shorting the common, and by selling these over-priced swaps to someone else. And with the Bankruptcy of Lehman, they were now the new Masters of the Universe! They won on their swaps, and in the obliterated common!
But look what happens when the bet unwinds. Morgan Stanley went from 12 to 34 in less than a day! Some of these sellers got stock from me at 33.65. And the swaps got cut in half. Yesterday afternoon, Doug Kass was on CNBC saying that these short selling restrictions were bogus. He said they it took him all of one minute to get a locate for a 500,000 share short on Morgan Stanley, therefore nobody was selling Morgan Stanley naked. Maybe that argument works in academia, but not in the real world!
The reaction was so vicious because this was a "pretend" raid, just like the raid on Goldman. 144 on Friday's pre-market? From 86 on Thursday?
Sometimes you can't game the system. Remember how Tom Brady of the Patriots for the last few years has always been on the probable list for a shoulder injury? Had he never not played? The first game of this season, he was finally off the list, and then he gets knocked out of the season with a knee injury.
The next weekend, the Jets were favored over the Patriots. Give me a break. I'm a Brett Favre fan, but I put my action on the Pats. Panic over-priced the odds.
The buyers of credit default swaps and shorters of common on Morgan Stanley and Goldman, were like those who had Brady as a quarterback in Fantasy Football. The fantasy players were wiped out. But the Pats' weren't.
So this bail-out doesn't just cure our problems, although it is a major step in the right direction. The bailout will have derivative effects. We saw it Friday. Bonds and the dollar got whacked, and oil went higher, but the market first had to wipe out the "fantasy" players who were gaming the system with their own brand of "financial terrorism" betting billions they could panic the system and bring it to their knees.
Now maybe panic has overpriced the odds on how successful this recovery will be. But it's harder to panic the solvency of the financial system, when the US government stands behind it. That may work in academia, but it doesn't sell in Main Street. Maybe that's the best consolation the bears have.
But the "financial terrorists?" They've been "Paulsoned!"
But they did one thing.
They forced the recovery!